During a recent conversation with a client, the topic of tax payments came up. Of course, the first tax deadline of the year just occurred so this topic is top of mind for many. There is no way around owing tax and in fact, you could choose to view it as one of the score cards for your business.
Tax owed = Congratulations, you have created a profitable healthy business
No Tax owed = Great! Consider this the starting point for creating a profitable NEW Year
A normal comment I hear from clients is: “there isn’t any cash available, how can I possibly owe tax”. Or worse yet: “I have no resources to pay the tax man, what happens now”. Both statements create stress, and for some, avoidance (and for others, tossing some of our hard earned dollars at Ben and Jerry, Pistachio Pistachio is Connie’s favorite). If you are drawing funds from the business to live on AND paying your bills, more than likely you have a profit and will owe tax. Instead of pulling funds out as fast as they are received, we recommend that you create a plan. A plan to intentionally pay yourself a salary AND set aside savings for Uncle Sam.
Paying Yourself (this will depend on your tax entity)
S Corporations (currently does not relate to single member LLC)
You must set yourself up for payroll and take at least an annual salary, this is an IRS requirement for your chosen tax entity. Depending on your cash flow, you may choose to do payroll more often. The tax preparers we’ve been working with the last couple of years want their clients to shoot for 50% of profits paid as payroll and the rest is available as a distribution. Depending on what your salary is you can pay into the tax system (federal and state withholding in lieu of estimated taxes) through your payroll, even if you only do an annual salary.
Other items to consider now that you have payroll. Please note, if you have any questions about these, check in with your tax professional for advice.
- For health insurance to be deductible, it needs to be included on the S-Corp Shareholder’s W2 as part of their taxable wages
- Pension benefits: there may be a reason to take a certain salary amount to max out your contributions
- Fringe benefits for you AND your team
Note – If you happen to be a C or regular corporation, the ONLY way to draw funds out is payroll unless you want to be double taxed. C corporations MUST discuss this with their tax professional to create a plan.
Sole Proprietor (Schedule C; includes single member LLC)
Legally there is no rule that you can’t also put yourself on payroll; but there are extra costs involved that can be avoided. There’s a difference between “taking payroll” (paying yourself) and “setting up payroll”. Setting yourself up on payroll will incur extra employer taxes (state, federal, unemployment) and possible processing fees. Now – I do like the thought process around “paying yourself” and I’d like to encourage all business owners to look at “taking payroll” using another system, like the Profit First model. The key word here is to intentionally pay yourself. Most sole proprietors I have worked with, including myself, drew funds out to survive on, but there was a disconnect in the thought pattern that the business was actually supporting them. More connection with how your business is using the funds is important. If you want to learn more about this method of payment, check out our blog post on Profit First here.
Establish 15% Tax Savings Account
I like this option regardless of what type of tax entity you have. Remember, we recommend only 50% of profits be paid as payroll for S Corporations, so there will still be tax owed on the remaining profit. This option of establishing a 15% tax savings account allocates funds at the time funds are received, either weekly or bi-monthly; this is the Profit First method. By allocating funds BEFORE you pay bills for your business, you are ensuring that there will be funds to support YOU, tax liability, and create a reserve account. Depending on your actual tax bracket, this percentage will change. If you are just starting out with Profit First and had a tax loss the prior year, you may start out much lower. One questions we hear, “what if I don’t need that reserve – since I don’t know what my tax liability will be I would rather use that allocation for personal funds (owners pay)”. That is your choice and remember, if there are funds for you to draw for personal use, more than likely that signals a profit and you will OWE tax.
If you do choose this option, then the funds will be saved and each quarter you will make an estimated tax payment. Quarterly estimated tax payments are necessary to make sure you pay 110% of the tax liability from the prior year to avoid any penalties. Now that you have funds saved, there is less stress on creating or finding the funds necessary to make these payments.
Your Relationship with Your Tax Professional
For all Corporations, having a tax professional on your team is a need, not a “desire” – as the guidance and assistance a tax professional gives to your business is invaluable, and will only lead to your success and longevity. We highly recommend that you find someone with whom you can have a steady relationship that includes good communication, an interest in the success of your business, and guidance that you can trust. We say it often across all our articles: not all tax professionals are created equal, so if your current situation doesn’t fit the bill, then look for the right fit. It might take one or two tries, but you should feel comfortable, supported, and like you’re getting expert advice and support.
A consultative relationship with your tax professional is the final key in planning for profit and tax needs. Best way to use this tool is to meet with your tax professional at least twice a year, BUT – meeting after the year is over does not count. Meet with your tax professional after your returns have been completed for the prior year to create a plan, around May is a great time for this. Then follow-up in October/November each year to review where you are at for the current year and make a plan about your tax liability that may include some tax savings options.
Getting it Done
Implementing these options is not hard (although fighting through the mindset resistance can be really, really tough). I know it may seem like you don’t have enough cash flow to pull these systems off; I know, because I implemented these items for myself and had to “get over it” to get it done. You can do it!
If you think you need more assistance or information to set up your own Profit First system, you can check out a few of our more recent articles: